What the words on you pound note actually mean

Ever wondered why x pound notes have the statement 'I promise to pay the bearer the sum of x pounds'?

If this statement makes no sense to you or seems ridiculous then it is because you do not understand modern money.

To understand it you need to understand what the essence of modern fiat money is, and what gives it value. Fiat money gets its value from the fact that it can be used to pay taxes owed to the government.

There are two sorts of money that are issued in all modern economies. First there is government money or state money, also called base money. Only the government or central bank (which is part of the government) can create this sort of money. Government money exists in two interchangeable forms: as central bank reserves, which are just numbers on a spreadsheet, and as physical cash (notes and coins). When notes and coins are issued central bank reserve accounts are marked down by the same amount. When the central bank or government receive cash they mark up the appropriate reserve account. The central bank reserves plus all the physical cash equals the monetary base. So physical cash is simply an easily transferable and anonymous form of government or state or base money.

The second form of money is commercial bank money. This is created by commercial banks and only exists in electronic form. 97% of the money that is available to the public to spend is this form of money. Commercial banks can create this money whenever they want and they do this whenever they make a loan. They simply increase the numbers in the bank account of the borrower by the amount of the loan. In return they get a debt from the borrower, which they mark as an asset, and they receive interest payment. Effectively they are renting the money to the borrower. It is important to recognise that bank money has no official status in that it cannot be used to make official payments to the government, such as paying taxes.

When you write a cheque to pay your tax bill to the government, on receipt of this cheque, goes to your bank and requires that your bank pay it that exact amount using government or state money. Banks can do this either using money in their reserve account at the central bank or by using physical cash.

It is because physical cash, unlike commercial bank money, can be used to pay taxes owed to the government that it says what it does on the notes. If you or anyone else produces these notes the government has to accept them as payments of tax owed to them or, if you are a bank, it has to credit your reserve account with that amount. You can't do this with commercial bank money.

So currency notes can be considered as transferable government IOUs that can be used to pay taxes or settle any other obligations to the government. If you are a bank and have a reserve account at the central bank they will credit your central bank reserve account by the same amount.

If this makes sense to you then you understand more about modern money than 99% of people, including most economists.